1

Suggested answer key for Case Study: The UK Energy Sector

(a)
(i)

(ii)

Compare the changes in UKs total imports and total exports of fuels
from 2002 to 2010.
Differences:
There is an overall increase in total imports of fuels whereas there is a
decrease in the total exports of fuels from 2002 to 2010.
Total imports changed at a faster rate (62.0%) compared to the changes in
total export (26.4%) from 2002 to 2010.
Given the information contained in Table 2, identify the fuel which UK
was increasingly dependent on over time.
UK was increasingly dependent on natural gas over time.
Prior to 2004, UK was a net exporter of natural gas. However from 2004
onwards, UK became a net importer of natural gas.
This implies a rising usage of natural gas in the UK as the net export value is
getting more negative over time.

(b)

Explain one factor which has led to the increase in liquefied natural gas
prices.
Japans nuclear reactor shutdown caused a decrease in supply of nuclear
energy as the production of nuclear energy is disrupted. Price of nuclear
energy will increase.
Given the disruption to nuclear energy production domestically and the rise in
domestic nuclear energy prices, Japan needs to source for alternative energy
sources. Consumers then switch over to consume LNG which is a substitute in
consumption. This drives up demand for LNG and hence increasing LNG
prices worldwide.

(c)

Extract 2 mentioned that gas flew from the high price area to the low
price area. Explain why such cross-border trade in the UK gas market
can be considered a distortion.
The price mechanism, through the interactions of demand and supply, plays an
important role of signalling where resources should be allocated. High prices
are signals from consumer of their high demand and supplier should increase
their output by reallocating resources away from the production of goods with
low prices (indicative of low demand).
This implies that goods should flow from a low price area to a high price area.
Hence when gas flew from the high price area (UK) to the low price area
(continental Europe) this is contrary to the price mechanism and thus the
cross-border trade in the UK gas market can be considered a distortion.

(d)

(e)

Explain why the gap between wholesale and retail energy prices
narrowed in 2011 as a result of well-publicised cost increases in the
wholesale market.
According to Table 1, wholesale costs of energy were the main driver and most
significant amongst various contributory factors to domestic energy price rises.
Well-publicised increases in the wholesale cost of energy provided greater
awareness and transparency of information for the consumers.
This reduced the ability of the energy firms to hide their profit margin and lead
to a fall in supplier margins which narrowed the gap between wholesale and
retail energy prices in 2011.

[2]

[3]

[2]

[2]

[3]

With reference to the data where appropriate, discuss the extent to

which energy firms in the UK can continue to pass on increases in

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wholesale prices to the consumers.

[8]

The extent to which the energy firms (producers) can shift or pass on the increase in
wholesale prices to the consumers depends on the relative price elasticities of demand and
supply which are determined by the factors affecting both the price elasticity of demand
(PED) and price elasticity of supply (PES)
Generally, the more price inelastic side of the market will pay for more of the cost increase
and bear a greater burden since it is less responsive to price changes.

Determinants of PED :
Substitutes (number + closeness), Degree of Necessity, Adjustment Time Period
PED < 1
Extract 4: A high proportion of customers are unlikely or unwilling to switch energy supplier in
the near future
Consumers ability to switch to alternative/rival energy firms is relatively low in the short run.
Over time (LR):
Extracts 3&4: if the UK Competition Commission launches inquiry into the energy sector, this
will force the firms to show greater transparency in their pricing structure allowing consumers
to make more informed decisions about which tariff plans are the best deal. In addition,
inquiry could result in greater contestability in the market.
Determinants of PES:
Type of Industry, Time Period, Level of Stock, Amt of spare Capacity, Barriers to Entry
PES <1
Utilities industry has limited ability to build up inventory level or expand spare capacity
quickly
High BTE given the high set up costs which might limit the number of firms in the industry
Over time (LR):
If the Competition Commission inquiry results in reduction in BTE into the industry
Over time, production capacity can be increased with new infrastructure being developed
Thesis: Energy firms in UK can continue to pass on a larger extent of increases in
wholesale prices to consumers (i.e. consumers bear a greater burden of the cost
increase)
This occurs when PED < PES i.e. demand is relatively less price elastic than supply
Increase in retail price is due to an increase in cost of production which shifts the SS curve of
the energy firms from S0 to S1 (refer to fig 1).
The per unit increase in COP is P 1P2, where P0P1 is borne by the consumers and P 0P2 is
borne by the producers.
Hence, consumers will bear a larger proportion of the increase in wholesale price and energy
firms can continue to pass on a larger extent of the cost increase to them.
Price

S1
S0

P1
Increase in
per unit COP

P0
P2

D0
Quantity

Q1 Q0
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Fig 1: PED < PES

Anti-Thesis: Energy firms in UK cannot continue to pass on increases in wholesale prices
to consumers (i.e. producers will bear a greater burden of the price increase)
This occurs when PED > PES i.e. demand is relatively more price elastic than supply
For a given per unit increase in COP, the portion borne by the consumer will be less than that
borne by the producers since the latter is the more price inelastic party of the two
Hence, energy firms will bear a larger proportion of the cost increase and cannot continue to
pass on a larger extent of the increase in wholesale price to consumers
L3

L2

L1
(f)

Developed discussion of the determinants of PED, PES with good

reference to case data, and both scenarios of relative
elasticities. Comes to a conclusion on the extent of who bears
the burden of costs increase in the longer term.
Developed explanation of the determinants of PED, PES and one
scenario of relative elasticities.
Undeveloped discussion of the determinants of PED, PES and
relative elasticities with limited attempt to link to case data
Smattering of valid points which show awareness of PED and PES

7-8

4-6

1-3

Extracts 3 and 4 suggest that the government should regulate the

market for energy in the UK. With the help of the extracts, discuss the
validity of this argument.

[10
]

Introduction:
Whether there is a cause for government regulation in the UK energy market depends on the
degree of MF and the cost effectiveness of the proposed modes of regulation.
Possible sources of MF: market imperfections (market dominance, imperfect info) resulting in
allocative inefficiency, productive inefficiency and inequity
Thesis: Govt should regulate the market
for energy in the UK
Market Imperfections: Market dominance
Extract 3: Big six energy firms able to pass on ST
spikes in prices as LT price increase to
consumers. Centrica reported highest ever
supernormal profits, and yet raised gas and
electricity prices, reduced consumer welfare.
Extract 4: Ofgem accused the utilities firms of
profiteering increasing dual-fuel customer by
733%
Implications:
Market structure of the UK energy firms seems to
be oligopoly with high barriers to entry which gave
rise to market power to influence price and earn
supernormal profits
Such market dominance leads to MF as allocative
and productive efficiencies cannot be achieved.
Fig 2: Since Qm<Qs, there is under-allocation of
resources. At output Qm, Pm>MC Allocative
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Anti-Thesis: Govt should not

regulate
the
market
for
energy in the UK
Supernormal profits and R&D
Supernormal profit earned may not
be excessive to warrant regulation.
Extract 4: RWE npower made just
1.50 profit on every 100 spent,
while making a loss per average
customer between 2004 and 2009
Extract 4: RWE has invested in
new,
more
efficient
energy
infrastructure in the UK for the last
3 years
Any attempt at regulation reduce
the ability and incentive of the
energy firms in investing in energy
infrastructure
Ability to tap on IEOS
Nature of energy market, greater

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inefficiency has also resulted in deadweight loss
to society indicated by the area ABC.

potential to tap on EOS and

reduce average cost of production
if the firms are allowed to operate
on a larger scale instead of being
forced to break up into smaller
entities.

Fig 2: Under-allocation of resources due to market

dominance
Market Imperfections: Imperfect Info
Extract 4: consumers are baffled by complexity of
energy market, varied and numerous tariff
choices which even the staff at energy companies
are unsure of the best deal option and may give
questionable advice
The UK energy market fails to allocate resources
efficiently due to imperfect info primarily in the
form of complex or misleading info
Consumers acting on such info make inefficient or
erroneous choices about which tariff plan and
which provider to subscribe to. Most consumers
would probably not be consuming the lowest cost
option to match their household needs.
Inequity

Extract 3: Energy price rises has led to increased

number of British households falling into fuel
poverty.

Energy is a basic necessity which should be

made affordable and accessible to all household,
especially the low-income groups to maintain a
satisfactory heating regime.

L3

Developed discussion of the arguments for the need for govt

intervention with good reference to case data. Reasoned
conclusion on the validity of argument.

7-10

L2

Developed explanation of the two main sources of MF (mkt

dominance with diagram, imperfect info) with good reference to
case data, largely one-sided argument for why they are cause
for govt intervention

5-6

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L1

Undeveloped discussion of the main sources of MF (mkt

dominance, imperfect info) with limited attempt to link to case
data
Smattering of valid points which show awareness of some sources of MF

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